Kochland by Christopher Leonard

Author:Christopher Leonard
Language: eng
Format: epub
Publisher: Simon & Schuster
Published: 2019-08-12T16:00:00+00:00

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For the first time since World War II, the economies of Japan, Europe, and the United States entered into a recession simultaneously. The impact on global oil markets was immediate and catastrophic. Oil fell from nearly $145 a barrel to roughly $35 a barrel in a matter of months. The reason was oversupply. When prices were high, oil companies ran at full throttle to produce as much crude as possible. When demand collapsed, all that oil was stranded, with no one to buy it. This oversupply created an obscure follow-on effect that was only visible to people like Koch’s oil traders in Houston. The markets entered a rare period that the traders called “contango.” Koch looked for gaps in the market, and this was one of the biggest in years.

It’s difficult for outsiders to even understand the nature of a contango market. In essence, the price of oil in spot markets, which reflect the price of oil today, tends to be lower than the price of oil to be delivered in the future. This is attributable to a host of complex reasons.I In the relatively rare scenario when oil today is cheaper than oil in the future, the markets are said to be in contango, and it doesn’t tend to last very long. Usually the market reverts to its normal state of cheaper oil in the future.

When the market goes into contango, it presents a whole host of ways for Koch’s traders to profit. In late 2008, the potential profits were extraordinary. The size of the contango became enormous—the gap between oil sold today and oil sold for delivery a few months out became roughly $8 a barrel. A more common level of contango would be in the range of $2 or $4 a barrel. And the gap wasn’t just wide, it was long-lasting. The markets remained in contango for several months.

Koch Industries, and a handful of other giant oil producers, were able to exploit this gap in a special way. Because Koch Industries traded in both the futures markets and the physical markets, it could execute something called the “contango storage play.” One former senior trader within Koch Supply & Trading called the contango storage play a “bread-and-butter” strategy for Koch’s crude oil department.

The mechanics of the contango storage play seem deceptively simple. A trader at Koch Industries buys oil in the spot markets, where it is cheap. Then, the trader sells oil for delivery in the futures markets, where oil is more expensive. When the contango gap is $8, it is easy to picture how quickly the profits pile up. The trader can buy oil for $35 and sell it for $43, almost instantly.

There is a catch, however. To execute the contango storage play, the trader must be able to do something that most traders can’t do—they must be able to deliver the actual, physical oil in that future month. If a typical oil speculator—who did not own an oil refinery, storage tanks, or an oil tanker ship—tried to execute the contango storage trade, they could find themselves shut out.

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